In the Weeds with Performance Share Accounting

Transcription

1 In the Weeds with Performance Share Accounting Jon W. Burg, FSA, CEP, Partner at Aon Radford Mike Palermo, CEP, Vice President at Fidelity Investments Paul R. Moore, CEP, Accounting Manager at Cisco Systems

2 Topics for Cultivation Market-Based Performance-Based Goals/Deadlines/Dependencies Retirement Eligibility EPS Goals tied to stock price performance Generally valued using Monte Carlo simulation Objective measurement Expense not trued up for payout (similar to expense for expired stock option) Expense predictable except for approved future performance periods Goals tied to internal metrics Generally valued at market price at grant, less any dividend discount Interim measurements may require business judgment Expense trued up for payout Expense may be more variable Multiple valuations may be required and valuations may change All periods may be valued upon authorization or upon beginning of each period Amortization may be graded or straight-line Different effects on expense and dilution Probability assessment effects on expense and dilution More variable than for time-based awards and calculation more complex -2-

3 Measuring Performance 50% 40% 43% 30% 27% 20% 21% 17% 14% 10% 10% 10% 8% 7% 7% 5% 5% 5% 5% 4% 4% 3% 3% 3% 3% 2% 2% 2% 1% 0% 0% Value Metrics: 58% Return/Margin Metrics: 38% Revenue/Profit Metrics: 60% Strategic Metrics: 14% -3-

4 FMV and Amortization Condition Accounting Example Single Goal, Single Performance Period Single Goal, Multiple Performance Periods Multiple Dependent Goals Multiple Independent Goals, Defined upfront Multiple Independent Goals, Definition Deferred Single FMV, Expense Straight-line over Performance Period FMV tied to Most Likely Performance Period; May Change; Straight-Line Amortization Multiple FMVs, Concurrent Graded Amortization Multiple FMVs determined at Grant, Consecutive Straight-Line Amortization Multiple FMVs determined at start of each performance period, Consecutive Straight-Line Amortization $10M in sales in 2016 Payout of 100% if $10M in sales by 12/31/2016; Payout of 50% if $10M in sales by 3/31/2017 Finish new product and sell 100 units by 7/1/2016; Finish Version 2 of that product and sell an additional 100 units by 12/31/2016 Sell $10M of product A by 5/1/2016 and sell $5M worth of product B by 9/1/ year sales incentive: goal of $10M for first fiscal year; goals for the second and third fiscal years established at the beginning of each of those years -4-

5 Performance-Based Varieties Performance conditions are one varietal of performance metric and enjoy their own accounting framework Nice and easy valuation Performance Conditions Fair Value Fair value is based on grant date stock price There may be an adjustment dependent upon treatment of dividends Same treatment as equivalent time-based awards Expense Amortization Expense will equal the actual number of awards earned multiplied by the fair value Company estimates the awards expected to vest and adjusts the accrual up or down to match Forfeitures Expense is reversed for any individual who terminates prior to the completion of the performance period We will cover the complications on expense recognition shortly -5-

6 Performance-Based Varieties The FMV could change over the life of an award Assume: 100 shares awarded with performance condition. Market price $30, dividends paid quarterly Performance conditions: Case A: Condition is met within 18 months and shares pay out at 18 months: Valuation: $26 Case B: Condition is met within 24 months, and shares pay out at 24 months: Valuation: $25 The FMV is discounted more for Case B because more dividends are missed from the grant date to the payout of the shares. Amortization (ignoring forfeiture rate provision): At grant, Case B is deemed to be most probable Amortization of the total value of $2,500 is begun over a 24-month period A total of $1,250 is amortized over the first 12 months After 12 months, Case A is deemed to be most probable Total value is now $2,600 based on the grant date FMV for Case A A catch-up expense for the first 12 months of $ is recorded ($2,600/18*12)-$1,250 This brings the total expense amortized to $1, The remaining $ is amortized over the remaining 6 months -6-

7 Market-Based Varieties Market conditions are another varietal of performance metric with its own accounting framework Market Conditions Fair Value Fair value is determined using a valuation model Monte Carlo simulation is most likely model Valuation model takes into account all possible outcomes Expense Amortization Expense is equal to the target number of awards multiplied by the fair value Expense amortization is not increased or decreased based on the expected or actual outcome Forfeitures Expense is reversed for any individual that terminates prior to the completion of the performance period Besides hiring a specialist for the valuation, what is advanced about market condition valuations? Example: Are market conditions more expensive? Example: Does a grant date after the performance period complicate things? -7-

8 Market-Based Varieties Sim 1 results in 150% Payout Sim 2 results in 100% Payout Sim 3 results in 0% Payout Sim 1 Value: 150% x $20 = $30 Sim 2 Value: 100% x $ 9 = $ 9 Sim 3 Value: 0% x $ 3 = $ 0 Average Value = $13 Premium of 30% -8-

9 Market-Based Varieties The fair value of a market condition must capture known information at the time of the grant If the stock price increases, the fair value will reflect the increase Grant Date Beginning Average Performance Period Known Information Projected Period (Monte Carlo Simulation) -9-

10 Market-Based Varieties The following example illustrates the potential impact of this grant date and performance period timing Stock Price on 1/1 $100 $100 $100 $100 $100 Stock Price on 3/1 $100 $105 $110 $110 $90 Percentile Rank 50 th 50 th 60 th 40 th 60 th Pro Forma Fair Value (as a % of grant price) Grant Date Fair Value (as a % of grant price) $100, 100% $105, 100% $110, 100% $110, 100% $90, 100% $100, 100% $105, 100% $120, 109% $100, 91% $100, 111% Percentage (%) 0% 0% 9% (9)% 11% We often refer to this timing disconnect as the stub period It can be managed through design and timing, but it cannot be predicted -10-

11 Assessing Probable Outcomes (Increase) Company ABC grants target 100 awards 3-year performance period Payout schedule of 0% to 200% of target based on EBITDA Fair Market Value and Fair Value are $30 Company ABC initially expects to pay out at 100% and amortizes accordingly Grant Date Year 1 Year 2 Year 3 Assumed Payout Percent (EOY) 100% 100% 100% 100% Total Expense Required $3,000 $3,000 $3,000 $3,000 Proportion to Recognize 33.3% 66.7% 100.0% Cumulative Expense Accrual $1,000 $2,000 $3,000 Annual Expense Accrual $1,000 $1,000 $1,

12 Assessing Probable Outcomes (Increase) Company revises assessment to 150% at the end of year 2: Grant Date Year 1 Year 2 Year 3 Assumed Payout Percent (EOY) 100% 100% 150% 150% Total Expense Required $3,000 $3,000 $4,500 $4,500 Proportion to Recognize 33.3% 66.7% 100.0% Cumulative Expense Accrual $1,000 $3,000 $4,500 Annual Expense Accrual $1,000 $2,000 $1,500 Company takes cumulative charge to reflect for additional shares expected to vest and increases future accrual -12-

13 Assessing Probable Outcomes (Decrease) Same example, but the company revises assessment to 75% at the beginning of year 2: Timing Grant Year 1 Year 2 Year 3 Expected Payout 100% 100% 75% 75% Total Expense to Recognize $3,000 $3,000 $2,250 $2,250 Percentage of Award to Recognize 33.3% 66.7% 100.0% Annual Expense Accrual $1,000 $625 $625 Cumulative Expense Accrual $1,000 $1,625 $2,250 The unamortized expense is adjusted prospectively when the expected to vest percentage is lowered If it is reduced to 0%, the expense recognition ceases and previous expense is not reversed until the end of the performance period -13-

14 Integrated Performance and Market Program Company ABC grants 100 target awards Three-year performance period based on both EPS growth and relative TSR Payout can range from 0% to 150% based on EPS growth metric Payout can be modified 67% to 133% based on relative TSR rank Total payout ranges from 0% to 200% EPS Metric Relative TSR Metric Total Growth Payout Ranking Modifier Payout Maximum 150% 75th %ile 133% 100% to 200% Target 100% 50th %ile 100% 67% to 133% Threshold 50% x 25th %ile 67% = 33% to 67% Minimum 0% 0% How does Company ABC handle an award with both performance and market conditions? The fair value incorporates the terms of the market condition as if it were a stand-alone program Expense recognition based on EPS growth as if it were a stand-alone plan, except use the fair value developed above instead of the stock price at grant Expense adjusted for changes in payout based on EPS metric only; no adjustment made for relative TSR performance If EPS performance results in 0% payout, no expense is recorded -14-

15 Integrated Performance and Market Program Company grants 1,000 PSUs with the following Stock price is $20 Fair value is $25 Company initially expects EPS growth at target (i.e., 100%) Timing Grant Year 1 Year 2 Year 3 EPS Growth 100% 100% 100% 100% Relative TSR Modifier 100% 100% 100% 100% Total Expense to Recognize $25,000 Percentage of Award to Recognize 33.3% 66.7% 100.0% Annual Expense Accrual $8,333 $8,333 $8,333 Cumulative Expense Accrual $8,333 $16,667 $25,000 In year 2, the company revises the EPS growth to max (150%) and Relative TSR is currently below the 25 th percentile (67% modifier) Timing Grant Year 1 Year 2 Year 3 EPS Growth 100% 100% 150% 150% Relative TSR Modifier 100% 100% 67% 67% Total Expense to Recognize $25,000 $25,000 $37,500 $37,500 Percentage of Award to Recognize 33.3% 66.7% 100.0% Annual Expense Accrual $8,333 $16,667 $12,500 Cumulative Expense Accrual $8,333 $25,000 $37,

16 Integrated Performance and Market Program The EPS growth ended at the max (150%) and Relative TSR ranked above the 75 th percentile (133% modifier), resulting in a full 200% payout Timing Grant Year 1 Year 2 Year 3 EPS Growth 100% 100% 150% 150% Relative TSR Modifier 100% 100% 67% 133% Total Expense to Recognize $25,000 $25,000 $37,500 $37,500 Percentage of Award to Recognize 33.3% 66.7% 100.0% Annual Expense Accrual $8,333 $16,667 $12,500 Cumulative Expense Accrual $8,333 $25,000 $37,500 The annual expense accrual in year 3 did not change since the actual EPS growth payout was not changed The company recorded expense based on 150% payout even though participants received 200% payout -16-

17 Defining the Grant Date Mutual understanding of terms and conditions of the program Beyond the standard T&Cs, the specific goals must be defined Example of defined goal Sales of 1 million units by 2016 Stock price hurdle of $50 Example of undefined goal Three separate goals for 2013, 2014, and 2015, but each goal is set at beginning of the year A grant date does not exist for the 2014 and 2015 measures Board approval Usually required unless approval is a forgone conclusion Expense is generally amortized from the grant date to the end of performance period, but exceptions exist -17-

18 Grant Date vs. Service Inception Date Service inception date is the date at which the requisite service period begins Grant Date = Service Inception Date Fair values determined at Grant Date Grant Date < Service Inception Date Fair values determined at Grant Date Grant Date > Service Inception Date Fair values determined when each metric is set Tranche 1 Tranche 2 Tranche 3 Tranche 4 Year 1 Year 2 Year 3 Year 4 Total 52.08% 27.08% 14.58% 6.25% Tranche 1 Tranche 2 Tranche 3 Tranche 4 Year 1 Year 2 Year 3 Year 4 Total 25.00% 25.00% 25.00% 25.00% Tranche 1 Tranche 2 Tranche 3 Tranche 4 Year 1 Year 2 Year 3 Year 4 Total 25.00% 25.00% 25.00% 25.00% -18-

19 Grant Date vs. Service Inception Case 1: Grant Date = Service Inception Date Facts: Board approval on January 1, 2016 for an award for 300 shares Performance goal of sales of $50M for the calendar year 2016 If goal is met 100 shares pay out on each of 12/31/16, 12/31/17, 12/31/18 Market price on January 1, 2016 is $15/share; non-dividend company Business assessment is that goal will be met FMV of $4,500 set on grant date January 1, 2016 Amortization: $1,500 amortized from January 1, 2016 through December 31, 2016 $1,500 amortized from January 1, 2016 through December 31, 2017 $1,500 amortized from January 1, 2016 through December 31,

20 Grant Date vs. Service Inception Case 2: Grant Date < Service Inception Date Facts: Board approval on January 1, 2016 for an award for 300 shares Performance goal of sales of $50M for each of the next 3 calendar years Performance Periods begin on January 1 of each calendar year 100 shares pay out at end of each year that goal is met Market price on January 1, 2016 is $15/share; non-dividend company Business assessment is that goal will be met FMV of $4,500 set on grant date January 1, 2016 for all 300 shares Amortization: $1,500 amortized from January 1, 2016 through December 31, 2016 $1,500 amortized from January 1, 2017 through December 31, 2017 $1,500 amortized from January 1, 2018 through December 31,

21 Grant Date vs. Service Inception Case 3: Grant Date > Service Inception Date Facts: Board approval on January 1, 2016 for an award for 300 shares Performance goal of sales of $50M for the calendar year 2016 Performance goals for next 2 years to be determined at start of each year 100 shares pay out at end of each year that goal is met Market price on January 1, 2016 is $15/share; non-dividend company Business assessment is that goal will be met FMV of $1,500 set on grant date January 1, 2016 for 100 shares FMV for remaining shares set when goals are established for each year Amortization: $1,500 amortized from January 1, 2016 through December 31, 2016 $x,xxx amortized from January 1, 2017 through December 31, 2017 $x,xxx amortized from January 1, 2018 through December 31,

22 Ripe for Retirement Retirement eligibility for performance shares generally shortens the service vesting period but not the performance period Expense is amortized over the service period, generally from the grant date through the retirement eligible date Shares included in basic only after both service and performance conditions are met Retirement provisions can make the expense front-loaded Example: 100 shares granted on January 1 with a 3-year cliff vest with a single 3-year performance condition FMV=$9/share Employee retirement eligible at end of year 1 Years 1 and 2 probability assessment is 100%; beginning of year 3 probability assessment is 150% Payout at end of year 3 is 150% Expense Disclosure Year 1 $900 Granted/Unvested: 100 shares Year 2 $0 Unvested: 100 shares Year 3 $450 Granted: 50 shares; Vested: 150 shares -22-

23 Earnings Per Share Considered contingency for purposes of applying EPS guidance in ASC 260 Determine if shares are contingently issuable Measure performance at end of reporting period and determine how many shares would be issued if performance period ended If condition met (or partially met), include shares as of beginning of reporting period or grant date if later Apply Treasury Stock Method to shares considered issuable (ASC ) If performance/market condition not satisfied by end of period Shares are not considered issuable for diluted EPS, exclude them from calculation However, compensation cost related to those awards included in earnings if it is probable that performance condition will ultimately be satisfied -23-

24 Earnings Per Share Payout Details If the stock price at the end of the performance period is: $8 150% payout $6 100% payout $4 50% payout Anything lower 0% payout Market Condition Performance period: 1 year Target awards: 5.0M (weighted average during period) Total expense: $40.0M Average stock price: $6 (simple average during period) Fair value: $8 (original grant date FV) -24-

25 Earnings Per Share Determination of Dilutive Impact Q1 Average price of $6 $3.99 stock price at the end of the reporting period These shares were not contingently issuable at the end of the reporting period and have no potential dilutive impact Determination of Dilutive Impact Q2 Average price of $6 $5.99 stock price at the end of the reporting period Potentially diluted awards: 5.0M x 50% = 2.5M shares Proceeds to buy back shares: $25.0M expense + ($6 x 2.5M shares - $8 FV x 5.0M shares) x 40% = $15.0M Shares repurchased: 15.0M/ $6 = 2.5M shares Dilutive shares: 5.0M x 50% - 2.5M = 0M shares -25-

26 Earnings Per Share Determination of Dilutive Impact Q3 Average price of $6 / $7.99 stock price at the end of the reporting period Potentially diluted awards: 5.0M x 100% = 5M shares Proceeds to buy back shares: $15.0M expense + ($6 x 5.0M shares - $8 FV x 5.0M shares) x 40% = $11.0M Shares repurchased: 11.0M / $6 = 1.8M shares Dilutive shares: 5.0M x 100% - 1.8M = 3.2M shares Determination of Dilutive Impact Q4 Average price of $6 / $9 stock price at the end of the reporting period Potentially diluted awards: 5.0M x 150% = 7.5M shares Proceeds to buy back shares: $5.0M expense + ($6 x 7.5M shares - $8 FV x 5.0M shares) x 40% = $7.0M Shares repurchased: 7.0M / $6 = 1.2M shares Dilutive shares: 5.0M x 150% - 1.2M = 6.3M shares -26-

27 Share Reserves/Disclosures Not uniform, but most: For plan reserves: Deduct shares from reserve at approval (including future performance periods) assuming max payout and true-up upon share issuance (don t forget about share withholding and fungible ratios) For 10Q and 10K roll forward: Disclose unvested at target amount when granted (excluding future performance periods) and show additional granted or forfeited shares upon payout Watch for issues in common with other stock units: Unvested vs. outstanding Value of unvested shares vs. unamortized value of unvested shares -27-

28 System Considerations Multiple Periods Probability Assessments Valuation Changes Award Identification Retirement Eligibility Performance measurement period Expense amortization period Vesting period Expense for internal metrics based upon ultimate probability of reaching goal Dilution for internal metrics based upon theoretical payout at end of fiscal period Prospective true-up Cumulative true-up Tracking of awards associated with specific performance criteria and periods Different effects on expenses and disclosures Does the system have multiple tables for the multiple periods? Does the system know the logic for using the different tables? Do you need to enter separate periods as separate awards? Does the system have separate fields for dilution %, expense %, and participant view %? How does your system calculate expense when the FMV is changed? Does the system have user-defined fields that can be used for reporting and updating? Can you enter retirement eligible date at the award level? Can you control the effects on the dilutive calculation? -28-

29 Conclusion/Questions -29-

30 Contact Us Jon Burg, CEP Partner Aon Radford Paul Moore, CEP Accounting Manager Cisco Systems, Inc Michael Palermo, CEP Vice President Fidelity Stock Plan Services

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